Monthly Archives: April 2012

The bear call spread is a vertical credit spread. With a vertical credit spread the investor will sell a lower priced strike call option and purchase a farther out of the money call option as insurance to limit risk. The credit received is the premium received for the short call minus the premium paid for the long call. The maximum risk is defined as the distance between the strikes selected minus the net premium received. The bear call spread is used when your forecast for the underlying is neutral to bearish. To obtain the maximum credit we want the underlying to stay below the short call so that both options expire worthless and we collect the credit. Let’s look at an actual example that currently has decent profit potential. On April 27th, 2012, Amazon, AMZN closed at $226.85. If we look at the weekly call options that expire on May 4th, the $230 call will sell for $2.80 and the $235 call can be bought for $1.44. The net credit we’ll receive is $1.36 or $136 per contract. If we set our maximum allowable loss at $5,000 we’d use 13 contracts. The actual maximum loss would be $4,732, the theoretical profit or expected return would be $1,453 and the maximum profit would be $1,768. If AMZN rises to the lower strike at $230 you could close out the position or do some dynamic delta adjusting to control loss. The position could be adjusted by adding some long calls, short puts or buying some AMZN stock or any combination of those. The chart below shows the profit/loss points for this call spread.

Investors who have long term stock holdings may also want to use a bear call spread to produce income and have potential for upside gain. One of the disadvantages of the popular covered call strategy is that in exchange for the income received from the covered calls, the investor is forced to forgo upside gain. If the underlying fund makes a large upside move, the investor does not participate. With a bear call spread income is produced by selling out of the money calls and purchasing further out of the money calls in the same quantity. This way in the event that the stock makes a large upside move, the investor will participate and still receive some income. For example if our investor owns 100 shares of ABC at $25, she could sell one $30 call and buy one $35 call for a net credit. Above $30 the shares would get called away, but she would still own the $35 call. Therefore, if the stock were to rise above $35 she would still have unlimited profit potential from the remaining long call at the 35 strike.

No, I’m not discussing political leadership changes in a foreign country due to intervention or a coup. The term “regime change” also applies to the stock market. The stock market goes through regime changes or shifts. What the term refers to is the state of the market in terms of its trend and volatility. The majority of the time, the market trends quietly upwards with low volatility. These periods of low volatility are interrupted by brief periods of rapidly falling prices and high volatility. Without delving into the underlying mathematics of the econometric models that calculate regime change, it can be summed up in simple terms to mean that about 85% of the time the market will trend higher with low volatility. We’ll call this “state one”. About 15% of the time the market will be in “state two” characterized by falling prices with high volatility. The trend is approximately three times as large in the negative direction when the market is in state two. Also, when the market is in state two, it tends to revert to state one quickly with 90% probability.

Ok, so what does this type of quantitative research mean to investors? What it means is that if you invest in the market you should expect most of the time to see your portfolio increasing in value with modest price swings, but also expect to have those quiet periods interrupted by brief periods of rapidly falling prices with larger price swings. Long term investors can use the periods of falling prices to add to market positions. Investors with a shorter time horizon, like those who are already retired can find the state two periods to be very unsettling. Investors can always consider using some sort of hedging mechanism if the volatility is causing too many sleepless nights. Index options can be used to hedge downside risk as can some of the new volatility and inverse ETFs.

What this can mean for option traders is that if we are in a period of high volatility, we can expect the market to eventually return to normal which means that the high volatility will eventually subside and we can expect to profit from strategies that involve selling options and collecting premium.

The concept of expected return is critical for options traders to understand. The expected return is known as the weighted average outcome. The math is really simple and can be shown as follows; say you were considering an investment that had a 25% chance of a 20% return, a 25% chance of a 10% return, a 25% chance of a 5% return and a 25% chance of a -5% return. The formula would look like this;

As an options trader or if you use options to reduce risk and enhance return on your investment portfolio you need to get in the habit of using an option calculator and calculate the expected return on any position that you are considering. Options without an expected profit should not be used. Scan the market for strategies that have a positive expected return.

Say for example someone challenges you to a game of coin toss. You can pick heads or tails and you can play as long as you wish. If the payout was the same for either heads or tails say $1, there is no statistical advantage to the game and no reason to play. Now if you were the receive $2 when you won and only had to pay $1 when you lost, you’d have a huge statistical advantage and should play that game as much as you can.

Casino games are like the above example but the casino gets $1.05 when it wins and you get $.95 cents. When trading options, use an expected return calculator, find trades where the expected return is on your side and manage your risk always.

One of the advantages of trading options is their virtually unlimited flexibility. For any strategy or position considered there are numerous possibilities. If one is to consider all of the different strike prices and expirations to choose from the universe is huge. Now consider for a moment that for every option position there also exists a synthetic equivalent.

Say for example that you are considering purchasing a long call. Hypothetically, there are ten strikes for that option and also ten different expirations that could be used. That means that there are 100 different call options to evaluate to see what fits your market prognosis the best.

Now consider that there is also a synthetic equivalent to a long call. The equivalent is long stock plus a long put. There is only one long stock position to consider, but hypothetically assume that there are also ten strikes and ten expirations to consider for the long put. That means that in addition to the 100 call options to evaluate, you can also evaluate 100 long put positions to combine with the long stock. So now you have 200 different positions to consider.

That’s the beauty of using options, the possibilities are virtually unlimited and there is is no limit to the amount of creative thinking that can be applied.

Remember for each position there exists a synthetic equivalent. Here’s a table of the basic ones.

Long Stock = Long Call + Short Put

Short Put = Long Stock + Short Call

Long Put = Short Stock + Long Call

Long Call = Long Stock + Long Put

Short Call = Short Stock + Short Put

Short Stock = Long Put + Short Call

Since there are many complex option strategies to use, it makes sense that a synthetic equivalent could be used for any of the legs of a normal option strategy if it is advantageous.